Part 3: Masking Deterioration of the Underlying Collateral and Rearview Mirror Analysis

Along with rising leverage levels, the increase in direct private debt should also cause concerns about a developing bubble. For mid-size companies that are too small to enter the bond market but too big to simply rely on bank loans, private debt can be a good option. Private debt tracked by Preqin has increased four-fold over the last decade. Although there is a trend of decreasing returns, feedback shows that most investors think returns from private debt will meet or exceed their expectations.

However, attractive returns from private debt are fleeting because too many investors chasing yields have caused those yields to compress. When the next downturn comes, it will become clear that the low returns ultimately cannot compensate for the risks.

Similarly, there are an increasing number of investors in PE funds. Prequin (2018) showed that in 2018, Apollo IX completed fundraising of nearly $25 billion dollars, a record high level. Also, six well-known PE funds have recently closed or announced closures that combined, exceeded $100 billion in fundraising.⁷ Strong demand from investors leads to intense rivalry among fund managers. Consequently, some managers are paying 11–12 times EBITDA to secure deals, which is an even higher multiple than the previous peak in 2007. It is important to note that according to Warren Buffett, the long-term return for corporate equity risk is about 6 percent (Tully 2018). This environment of fierce competition makes it unlikely that PE funds will perform as strongly as they have in years prior. A principal at AQR, Antti Ilmanen, said, “Private equity doesn’t seem to offer as attractive an edge over public market counterparties as it did 15 or 20 years ago” (Ilmanen et al. 2019, 11). Analysts also warn that the PE industry may have reached a peak and caution that sustaining high performance in the coming years appears challenging. With so much money on the sidelines, one risk is that managers will end up overpaying for assets, thus reducing future returns. Exhibit 5 shows that the dry powder of PE totaled nearly $1 trillion by the end of 2017 (Espinoza 2018), meaning that more than 30 percent of the total AUM in PE funds was not invested.

Just because subprime auto loans “did well last time” doesn’t mean they are safe now. An example of a typical behavioral bias is overconfidence. This bias is exacerbated when it is supported by what has worked in the past. We use the auto loan market to illustrate this principle.

A colorful article on subprime auto loans that appeared in Zero Hedge in 2015 reported that the financial firm Skopos sold $154 million of asset-backed securities (ABS) in auto loans where 14 percent of the collateral pool of loans were from borrowers with no credit score. The rapid increase in the number of structured products sold to investors possessing a weak credit base ominously echoes the proliferation of similar structures that were packaged, sold, and backed by household borrowers for the NINJA loans that preceded the financial crisis of 2008: “NINJA” stood for no income, no job, or asset.

Exhibit 6 shows the growth of car loans. We can clearly see the growing trend, with car loans currently representing a total of $1.2 trillion of outstanding debt. From a behavioral perspective, we tend to think that because car loans were relatively safe during the financial crisis of 2008, they will be safe in future financial crises. Exhibit 7, however, shows that the delinquency rate of subprime auto loans has been steadily rising since 2011, reaching a historically high rate of 5.5 percent as of the beginning of 2019; prime auto loans maintained a delinquency rate lower than 0.5 percent over the same time period.

Subprime auto loans are tempting, providing easy access to credit for consumers who want to purchase status cars they cannot otherwise afford. This scenario is a clear harbinger of economic trouble for the sector. Additionally, when the economy takes a dip, many of these consumers will suddenly struggle to make car payments on a car they could barely afford to purchase even when the economy was strong. Investors would be wise to keep a vigilant eye on the auto loan markets: once this market descends into mass default, it is possible that those defaults will create a domino effect across the entire credit market.

Similar to the pattern of delinquency rates in the auto loan market, Exhibit 8 shows the delinquency rate of residential mortgages before and after the crisis. Two years prior to the financial crisis, the delinquency rate rapidly increased until it peaked in 2010; then it sharply dropped to its lowest point, where it stabilized at a level of 2–3 percent. The striking similarities between the delinquency rates of these two markets allows us to draw a supportable conclusion that a subprime auto loan bubble is developing and will likely traverse the same disastrous route as the subprime mortgage market in 2008.

Leveraged loan data. To put things in perspective, we now turn our attention to the leveraged loan market and compare it to the pre-crisis subprime mortgage market in 2006. This comparison is illustrative because a leveraged loan and a subprime mortgage share common features. A subprime mortgage is created for individuals with poor credit (a FICO score ranging between 500 to 600), in the same way that a leveraged loan is created for corporations with poor credit ratings.

According to the definition of S&P Leveraged Commentary & Data (LCD), a well-known provider of leveraged loan news and analytics, a leveraged loan is typically for borrowers with low credit ratings of BB– or lower, and additionally, any loan that has a borrowing rate of at least LIBOR plus 125 basis points and that has no current rating. Note that the definition of leveraged loans varies between different types of lenders.